Known unknowns and Guyana’s petroleum fiscal regime

As far as I can determine, a standard formulation of Guyana’s fiscal regime for its petroleum sector would describe this as ‘The Terms and Conditions that are applied to both the Owner (State) and Contractor (Exxon and its partners) for conducting their business within an integrated framework; from exploration activities, right through the production chain (upstream to downstream), as well as trading’. In other words, those laws and regulations that govern the distribution of economic benefits (gains) derived during this integrated business process. Such a regime would, therefore, determine 1) production and sales revenues generated; 2) allocation of risks between Owner and Contractor; 3) profitability of the petroleum business; and 4) the sustainability of investment flows to the sector.

When defined in this comprehensive manner, energy analysts share the consensus view that petroleum fiscal regimes are, principally, a function of five variables, namely, 1) its clarity/ stability/governance; 2) the instruments/tools/taxes utilized; 3) the administration/governance; 4) the broader economic context; and 5) the characteristics of Guyana’s petroleum finds (especially crude quality, location, and size). The metrics of these variables are typically measured using a variety of techniques, including interviews, expert-opinion assessments, surveys and the use of proxies. Given the variables identified, one can safely conclude that there are many “known unknowns” which help determine fiscal outcome.

At this juncture readers should similarly observe that I have not yet discussed individual instruments/tools/taxes in Guyana’s fiscal regime. It can be indicated, however, there is a wide variety to the individual items, which separately, and together, affect revenue yield, risk, profit allocation, and sustainability of investment flows.

Dynamics

Because worldwide, petroleum markets are characterized by massive uncertainties/ unknowns/ im-ponderables, this has led to enormous volatility of such variables as price, output, cost, and profit. These have ranged across all time periods: daily/seasonal/annual; short-term to long-term; and secular. Every fiscal regime will therefore reveal fluctuations in its relative yield. Economists identify three broad categories of such changes. Thus, fiscal regimes may be neutral, regressive, or progressive in their revenue yield.

The fiscal yield is termed neutral, if it sustains a constant share of revenue as profitability increases or decreases. It is regressive if the share of revenue yield declines as profitability increases or decreases. It is progressive if the share of revenue yield rises as profitability increases or decreases.

The terms applied above (neutral, regressive, progressive) should not be interpreted as value-judgments. Indeed, the fiscal regime may be deliberately designed to be regressive, neutral or progressive! These concepts are therefore, used objectively, and in terms of their effect on production, cost, price and profit.

Some examples may help with the interpretation of these concepts. Thus, the signature bonus (already paid by Exxon and its partners) is regressive, as it is independent of the price/output/ cost/profitability of the petroleum sector. Similarly, income taxes levied on profit (net income) would be neutral, as the rate in the tax code applies independent of price and profit. Following from this, if the cost recovery mechanism in Guyana’s 2016 PSA was operating on a sliding scale (for example, the R factor, described before) this would be progressive.

Another way of explaining this concept is captured by the use of the terms: front-end loading and back-end loading of taxes. The former circumstance applies to cases where revenue yield from the fiscal regime is obtained before costs are fully recovered by Exxon and partners, or the Contractor makes a profit. The latter term applies to the opposite situation, where the Government take becomes significant only after the Contractor makes a profit and fully recovers cost. Of course, the revenue yield is neutral if this happens only when profit is being made and costs are recovered. Designing the fiscal tools for achieving any of these outcomes is heavily reliant on the monitoring and auditing capability of the State.

This permits the classification of taxes by type. Front-end loaded taxes would be typified by the signature bonus; neutral taxes by the corporate income tax; and profit-based taxes would be classed as back-end loaded.

Two further observations should be noted here. First, it is incorrect to expect always that, if the prices of petroleum products rise, so will the profitability of Exxon and partners. While this is likely, there is no 100 per cent positive correlation in the movement of crude oil prices and the profitability of the producing firms. While there may be significant correlation, it would be most unwise to ignore the possibility of rising petroleum prices linked to stagnant or declining profit.

Second, the empirical data suggest that, if the Contractor’s profitability increases and the Government take rises too sharply, this could reduce the pace of investment flows into the sector. This observation basically re-states the truism, namely, the need to strike the right balance when allocating the size of the Government’s take and the sustainable expansion of investment flows into the sector.

Conclusion

The debate on Guyana’s 2016 Production Sharing Agreement (PSA) has, all too often, overlooked the policy trade-offs which the authorities have to make when designing a fiscal regime. In particular, as this design exists in a context where every existing petroleum contract is unique and imperfect, it follows, therefore, that every such contract can be theoretically improved. In my opinion, the authorities need not be defensive about criticisms of their ongoing negotiations, but instead urge contributors to express an option for making constructive critiques, as I have tried to do in these columns. Constructive critiques would seek to enhance Guyana’s economic gains, rather than focus on discrediting the negotiators; regretably, with witting and unwitting misspecifications, errors, and omissions masquerading as certainties.